Fed's Tarullo Talks About Zombie Banks — Part III

The issues involved in international financial regulation are very complex, and each one is full of nuance and raises further questions. This is the third article based on an interview of Federal Reserve Governor Daniel Tarullo, lead governor of the Fed for financial supervision, by Tim Adams, CEO of the powerful financial trade association Institute of International Finance at the group's Annual Membership Meeting held at the Ronald Reagan Building in Washington.

The IIF represents the largest banks in the world, whose regulation by people like Tarullo will influence the timing and course of the next episode of the ongoing financial crisis.

Adams invited Tarullo to talk some more about wholesale funding, which is one where Tarullo and the Financial Stability Oversight Council (FSOC) have directed considerable effort, because a breakdown in funding is often the precipitating event, even if it isn't the underlying cause, of episodes of the ongoing financial crisis. Tarullo referred to a consultative paper that is looking toward establishing common margin requirements for securities transactions, and he spoke of the U.S. imposing capital surcharges on the largest banks based on their wholesale funding vulnerabilities.

In addition, controversy continues over the Securities and Exchange Commission's proposed measures to respond to the threat the FSOC has identified as being posed by money market mutual funds that invest in the commercial paper of banks, where "breaking the buck" in a prominent fund was one of the triggers of the 2008 crisis episode.

Importantly, Tarullo acknowledged that while the front appears quiescent at the present time with respect to wholesale funding, continued innovation can pose risks that would need to be managed and regulated. He warned that not to realize the risks these developments can present would be to delude ourselves. (The capacity of the banks and their regulators to indulge in self-delusion in furtherance of short-term interests should never be underestimated.)

A questioner from a Russian news agency asked whether the EU's program of quantitative easing (QE) might presage global currency wars. This was the first mention of the elephant of QE in the discussion.

At first Tarullo spoke of the circumstance in Europe, but he then admitted concern about worldwide growth, and he suggested that there are more risks to the downside than to the upside, seeing hope for moderate growth in the U.S. and other regions having more downside risk.

Adams then asked what it would take to get back to a period of growth and prosperity such as the U.S. experience in the 1990s (neglecting to recognize that the policies that fed this artificial boom led to the bust that struck in the mid-2000s). Tarullo correctly pointed out that the structure of banking and finance has changed in the meantime, and there's no going back. He candidly pointed to aging capital stock, as old, he said, as any time in the postwar period, and issues of aggregate demand as the main challenges, and he concluded that any turnaround would be difficult and would not take the form of a "Nike swoosh."

In closing, Adams brought up the recent theme of "conduct and culture" at the biggest banks as raised recently by a conference at the New York Fed. Tarullo called culture "a slippery concept," and he asserted that regulators are trying to change expectations with respect to risk, conduct and compensation.

He noted that citizens worldwide reading the newspapers see that there aren't just a few bad apples in the industry, rather that something is wrong with the structure. After this burst of insight, he concluded that needed changes "are not going to manifest themselves immediately."

For this writer, Tarullo's remarks confirm the thesis that the U.S. is still mired in a financial crisis that extends back at least half a century, that the industry is still in charge of policy and that the only thing that has changed is that the embedded risk, while unknown, is greater than ever and is being temporarily masked by QE and regulatory forbearance.